No more free money.

Hollywood's Big Loss

No more free money from Germany.

Even though its focus may be far removed from the geopolitics of Europe, Hollywood has reason to be concerned with the recent results of the German elections. The newly designated Minister of Finance Peer Steinbrück announced on Nov. 12 that he was retroactively eliminating the part of the tax code that allows German investors in media funds to defer their taxes. This German tax shelter, as I have previously pointed out, provided Hollywood with an El Dorado of easy cash for the past quarter-century and allowed studios to increase their earnings without any risk. Now it is dead.

Historically, the rationale for such government subsidies was that local filmmakers could not survive without them. Since the 1970s, the American studios, with their enormous marketing muscle and their ability to send stars to foreign openings, had largely succeeded in replacing local European films with their own. The American studios' share of the box office in Europe grew from 30 percent by 1950 to over 80 percent by 1990. Moreover, European films without American stars could not count on being released other than in art houses in the American markets. Even successful European films such as the French comedy 3 Hommes et un Couffin (Three Men and a Baby), the French thriller La Femme Nikita, and the Franco-Dutch drama Spoorloos (The Vanishing),had to be remade with American stars in order to gain access to wide distribution in America.

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European governments, with their local filmmaking in danger of becoming either extinct or totally Americanized, moved to preserve it, and the cultural values these films represented, by providing subsidies and tax loopholes. For example, in France the film industry is subsidized by a hefty box-office tax on American films, the proceeds of which are distributed by Canal+ to French filmmakers. In Britain, filmmakers are awarded part of the proceeds from the national lottery and from the so-called Section 48 tax relief. In Germany, filmmakers are—or were until last week—largely financed through tax-sheltered media funds.

Hollywood studios, though they lack their own government tax relief, manage to join the party by having many of their films assume the identity of foreign co-productions. The studios deftly morph film productions so that they legally qualify as "German" or "English." The art of the deal comes in fully retaining both the control and the profits for themselves. This is why the German tax-shelter deals proved especially appealing. Unlike subsidies in other European countries, Germany didn't require that films be shot locally, use German actors, or employ German crews. The tax-code only required that the film be owned by a German company that theoretically could share in its earnings. No problem for Hollywood lawyers. They arranged the deal on paper so the studio nominally sold the movie's copyright to a German corporate shell, which would then lease back the copyright to the studio with an option to repurchase it after the tax shelter had reaped its rewards.

The sum total of the lease-payments and the repurchase price that the studio paid would be less than the purchase price the German corporation paid, so the studio was guaranteed a profit. The German corporate shell meanwhile entered into a "production service agreement" and a "distribution service agreement" that effectively returned all control to the studio. For their part the German media fund, which nominally (but not really) owns the movie, thus qualifies under the German tax code and its investors get the tax break.

For going through this charade, a studio walks away free and clear with a sum that typically amounts to between 8 percent and 10 percent of the budget—without taking any risks whatsoever. Even though they are rarely, if ever, publicly divulged, such profits greatly add to the studio's overall earnings. Paramount, for example, made between $70 million to $90 million in 2003 alone from the German tax shelter, which accounted for a large portion of its studio profits. As one Paramount executive told me, it was truly "money for nothing." Making a sweet deal even sweeter, the German tax shelter can be combined with other tax subsidies that merely require shooting a portion of the film in the particular country. New Line Cinema, for example, covered almost the entire cost of its Lord of the Rings trilogy by combining German tax shelters with New Zealand subsidies and preselling the film in a few foreign markets.

Unfortunately, although the German tax shelter turned out to be a golden goose for Hollywood studios, it didn't lay golden eggs for the German filmmakers. American movies have increased their share of the German box office, accounting for more than 85 percent of it last year. So, as I learned on a recent trip to Berlin, politicians find little justification to keep this loophole in the tax code. Hollywood, alas, will now have to find other equally imaginative ways to supplement its earnings.